For many businesses, small and large alike, tax day is a stressful burden. It usually follows a script, where the terrible final act ends in someone telling you that you owe the government thousands of dollars, for no reason other than you had another successful year at work. Whatever the field your business is in, sometimes it feels like the IRS is going out of its way to kill your sole member LLCs profits.
The reason for this is how self-employment income is treated, versus regularly paid W2 wages (such as those that would come from a regular 9 to 5 employer). When you work for someone else as a wage earning employee, your employer is responsible for 50% of a group of taxes collectively known as FICA tax. When you are your own boss, there's no one covering those for you, and so you can expect a 15.3% self employment tax tacked on to all of your business net earnings.
That's hardly something to look forward to, and many small business owners have turned to a wonderful tool to assist in reducing the taxes that they owe. The S-Corporation.
The Subchapter S serves as a middle ground for many business owners, allowing them to evade the double taxation of a full-on corporation while also allowing them the benefits of running a regarded entity. Here are some of the pros and cons of running a business as an S-corporation.
Pro #1.
Tax Savings. The most valuable benefit of an S-Corp, to many folks, is the upfront tax savings. This is easy to understand, because for established and successful businesses, the savings are quite significant. The reason for this is that by working as an employee of your S-corporation, in addition to still being its owner, you are eligible to pay yourself an industry average salary.
And when you pay yourself a salary, like any other salaried employee, your business fronts 50% of those social security and medicare taxes. Then your business enjoys the tangible benefit of deducting its portion of those taxes, reducing the amount of taxable distributions you pay on your tax bill!
Pro #2.
Self employment tax-free earnings as distributions. In point 1, it was mentioned that you are able to pay yourself a reasonable salary. So what happens to the rest of the money over that salary? It gets paid out to you as a business distribution, which just so happens to NOT be subject to self employment earnings!
As an example, lets say your run a sole-member LLC, and you bring in $90,000 in gross annual income. From that, it has to pay about $30,000 in materials, supplies, and other operating costs, leaving the business profitable with a net income of $60,000.
As a a sole member LLC, then that's pretty much the end of the equation. We apply a 15.3% self employment tax to those earnings, a hefty $9,180, on top of your regular income taxes. There are some other factors we won't go over here, but in a nutshell that's how it works.
Now lets look at that business under an S-corporation model. Let's use the same $90,000 in gross income and the same $30,000 in operating costs. Now, we add the next step, a paid salary from the company. Wages paid have to be reasonable, so you can't pay yourself a dollar and a diet coke. The easiest way to do this is to just google your career field (maybe check out the Department of Labor stats!), and see where your median salary range is, then adjust for cost of living in your state.
For another example, the average salary of a consultant in New York is around $85,000. The average salary of the same consultant in Oklahoma is about $42,000. To review, our S-corporation has $90,000 in gross income and $30,000 in operating costs. It also pays you a salary of $35,000. The remaining business profit would be paid out as a distribution (not subject to self-employment tax!), and get added in to your adjusted gross income to figure your overall tax rate. The real advantage though, is we reduced our Social Security and Medicare taxes to $5,355, computed on your W2. That's over $3,000 in savings without figuring in business deductions for paying those taxes on your behalf!
As great as this is, nothing is perfect.
Con #1.
The biggest drawback to the S-corporation election is that it comes with increased administrative costs. First, you will need to file a second tax return. Most firms charge more money for a corporate return than a personal one, so the cost is likely going to be significant. At Pelican we are proud of our competitive pricing - corporate returns start at just $150!
Second, S-Corporations have to be filed in order to generate the forms you need to finish your personal return. They also have earlier tax deadlines, with a filing deadline of March 15th.
Third, in order to pay yourself a salary, you will need a payroll professional, or be willing to tackle the task yourself. There are many penalties that are associated with payroll tax errors, so using the "trial-by-error" method is not advised.
So is it worth it?
The largest factor in determining if an S-corp is right for most people is sustained business profits. On average, a business needs to have a net income of at least $50,000 in order to really see large tax savings with an S-corporation. Anything less than that, and the administrative costs - which could range anywhere from $1,800 to $3,000 annually - are more expensive than the tax savings you get from filing the S election.
For many though, as long as business income is both sustained and significant, they can save considerable amounts on their tax burdens by switching to an S-corp. If you think this might be right for you, schedule a consultation with us and we can take a look! At worst, nothing changes. At best, you can finally hold on to little bit more of what you've earned.
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